381 Computational Finance

Tutorial 4: Stocks and Their Valuation

February 7, 2006

Question 1
A company has just paid a dividend of £3 per share. The dividend is expected to grow at
a rate of 10% forever. What is the stock price if the required rate of return is 12%?
Answer 1
We apply the constant dividend growth formula. Since the current dividend is D0 = 3, the
period 1 dividend is D1 = D0 (1 + g) and g = 10%.
D1
P0 =
re − g
D0 (1 + g)
=
re − g
3(1 + 0.10)
= = £165
0.12 − 0.10
Question 2
A company has just paid the dividend of £2 per share. The company has expected the
rate of growth in dividends per year for 3 years as 15% and then 10% per year thereafter.
What is the new stock price if the required return remains at 12%?
Answer 2
The cash flow is presented in the following table.

Time 0 1 2 3 4 5 ···
Cash D0 D1 D2 D3 D4 D5 ···
Flow 2 2(1 + 0.15) 2(1 + 0.15)2 2(1 + 0.15)3 D3 (1 + 0.10) D3 (1 + 0.10)2 ···
2 2.3 2.645 3.04175 3.04175(1+0.10) 3.04175(1 + 0.10)2 ···
Since the stock pays dividends at 15% for 3 years, the present value of the first three
dividends, P V (D1 , D2 , D3 ) is computed as
2.3 2.645 3.04175
P V (D1 , D2 , D3 ) = + + = 6.327207
1.12 1.122 1.123
Since the stock pays dividends at a constant rate forever after year 3, we find the price of
the stock at the end of the year 3 using the constant growth formula as
D4
P3 =
re − g
D3 (1 + g)
=
re − g
3.04175(1 + 0.10)
= = 167.2963
0.12 − 0.10

1
 Computational Finance 2

Then the present value of the stock price in year 3 is

167.2963
P V (P3 ) = = 119.078
(1 + 0.12)3

The current stock price is the sum of the present value of the first three dividends and the
present value of the stock price in year 3.

P0 = P V (D1 , D2 , D3 ) + P V (P3 ) = £125.4052

Question 3

Suppose that for Company X, the earnings and consequently dividends are expected to
grow at 8% rate per year forever. The current earnings and dividends per share are 2.30
and 0.92, respectively. The required rate of return on similiar investments is 12%.

1. What are the current stock price and the P/E ratio?

2. Because of the new product, the company expects the growth on dividends as 9%.
What are the new price and the P/E ratio?

3. What absolute percentage gain has an investor realised in his investment?

Answer 3

1. Here, g = 8%, E0 = 2.30, D0 = 0.92 and re = 12%. From the constant dividend
growth formula, the current stock price is computed as
D1
P0 =
re − g
D0 (1 + g)
=
re − g
0.92(1 + 0.08)
= = 24.84
0.12 − 0.08

P0 24.84
= = 10.8
E0 2.30

2. Now, the growth on dividends is expected to increase from 8% to 9%. Therefore, the
current price PN is found as follows;

D0 (1 + g)
PN =
re − g
0.92(1 + 0.09)
=
0.12 − 0.09
= 33.4266

and the P/E ratio is

PN 33.4266
= = 14.53
E0 2.30
 Computational Finance 3

3. The absolute gain is the difference between the PN and P0

GainAbsolute = PN − P0
= 33.4266 − 24.84 = 8.5866

and the absolute percentage gain is computed as

PN − P0
GainP ercentage =
P0
8.5866
= = 34.56%
24.84